Japan Fears And The Retail Sell-Off

Retail stockscontinue on their slide as investors worry about the world's second largest consumer market.

I decided to ask Brian Sozzi, a StarMine top-ranked Equity Research Retail analyst, about his outlook on the sector.

LL:Japan is a supplier to the world. Now we are hearing that some products might have to be tested for radiation. What are your retail sources telling you?

Brian Sozzi: Thus far, the supply chain situation for retailers is not as dire as one would expect amidst all the heart-wrenching headlines and photographs. While the movement of goods and services throughout Japan has taken a hit, sparking sharply lower production from chip suppliers to car producers, the not so detrimental impact to retail reflects where the sector is structural speaking. By that I mean diversification. As the costs of production have climbed appreciably since the economic fallout concluded, retailers have made it a top priority to shift production from a high cost region in Japan, and a creeping inflationary country in China, to the likes of Egypt, Philippines, Vietnam, Nicaragua, and in some instances back to the United States.

Two great examples of the supply chain diversification I speak of are Gap and Abercrombie & Fitch. Gap has a vendor base of some 600 spread throughout 60 countries worldwide, with no vendor accounting for more than 3% of purchases. Abercrombie & Fitch has broadened its supply chain to Central and South America, and no vendor comprises greater than 5% of its purchases. Moreover, many retailers have taken advanced receipt of products that are set to arrive in stores in the next few months, so an immediate disruption in most product classifications is unlikely.

Make no mistake, Japan is a player in the global supply chain, and products produced there could very well be a cog in the supply chain of a plant in China, which in turn supplies a retailer with a finished product for sale. If we learned anything from the leverage bust, it’s that the world is interconnected.

Regarding my discussions with contacts, many have characterized things as being at a temporary standstill. Products are not flowing smoothly, and product out of stocks in food is being noted. Empty shelves are normally music to the ears of retailers as it signals strong demand, but the demand we are seeing in Japan is for basic necessities that may not be replenished quickly. Rolling blackouts, damaged roads and lines of communication are impediments to the supply chain currently.

LL: What kind of impact will this have on global retailers?

Brian Sozzi: There has been no earnings warnings yet by global retailers, but I attribute that to companies going through different internal modeling scenarios and then discussions on how to convey the message to the Street. The impact will be felt in numerous ways. First, a company must think about the structural damage to infrastructure in Japan, which includes people and hard assets. From the discussions I have had with contacts, the structural damage has been modest (stores and offices not located near rural areas) and human life spared. Second, a scenario analysis must be done because the closing of stores for an undetermined amount of time will trigger shortfalls on sales and earnings from Japanese businesses. That element of unknown is why shares of retailers with outsized Japan exposure have sold off in the manner they are, the market is pricing in a greater risk component to future earnings (tail risk included). Third, a new plan of attack will need to be constructed in terms of growth initiatives in Japan, and perhaps internationally more broadly, given the associated risk factors. Costs to open up a store in Japan are likely to spike as there will be a shortage of labor and materials.

Ultimately, the impact will take a psychological toll on three sets of consumers, tourist and business travelers and the Japanese locals.

Japan was the number one foreign destination for Chinese tourists last year, with a record 1.97 million visitors, up 26% from 2009. In total, Japan attracted 8.6 million visitors last year of which 727,000 were from the United States. The strong travel component to Japan explains why Abercrombie & Fitch opened a hulking flagship store in the Ginza (Tokyo) district in 2010. A slowdown in travel equates to reduced sales and profit expectations for flagship destinations. As for the savings minded local Japanese, the reduced level of confidence may spur further cautiousness.

LL: What about Western retailers?

Brian Sozzi: If one is an investor in the retail sector, the weekend should have been used to establish a list, after conducting due diligence, breaking down those retailers that are global and those are Western.

Wal-Mart is global in terms of Japanese store exposure (operates under the Seiyu banner) and supply chain (has focused as of late on locally sourcing products for Seiyu). The aforementioned Abercrombie & Fitch has become a global player, operating namesake flagship stores and mall-based Hollister stores in international markets that may be hurt near-term from reduced tourist travel (higher airfare prices also a consideration). Until the dust settles, shares of global retailers, which were heavily sought after by investors in 2010 as a medium to gain access to emerging markets (China and India) could lag Western only retailers, which may only get a fraction of their supplies from Japan and lack a physical store presence. Names that investors should place on their radar screen for a trade once market sentiment stabilizes are Ann Taylor , American Eagle Outfitters , and Big Lots , all being retailers with limited direct contact with Japan and that are valued attractively relative to their future projected earnings.

LL: What kind of financial impact will this have on the luxury retail sector?

Brian Sozzi: Psychology is the top consideration at the moment with this sector of retail. How long will tourism be depressed to hotspot destinations in Japan? How will the devastation in Japan weigh on consumer spending in the United States, specifically as the wealth effect is diminished with the pullback in equities markets and $4.00 a gallon plus gasoline? Does a potential selling of treasuries by Japan jack up borrowing rates and hamper the economic recovery? These are some of the questions the market is wrestling with since the news hit the tape last week.

I attribute the stronger sell-offs in shares of Tiffany & Co. and Coach this week to the premiums the stocks are valued at when compared to the broader retail sector and equities markets.

Consequently, any swift decline in sales, despite muddling growth in the country for each, raises the risk to future earnings. Both companies, in my view, have been managing their Japanese businesses to profitability rather than new unit growth.

Note to investors. It's not the amount of sales in which retailers derive from Japan per se, it's the store clustering in close proximity damaged areas and the profit generated by operations in Japan. Due to the sluggish growth and deflationary forces in the country, profit margins generally are thinner compared to other international markets these companies conduct business.

Drilldown into Tiffany & Co. and Coach:

- Tiffany & Co. stores are clustered along the coast of Japan

- Coach has a store around the Fukushima area (nuclear concern central) and in Sendai

LL: The human capital is what’s most important here. What are the retailers doing to help their employees? How many estimated lives lost?

Brian Sozzi: Human capital, as you so correctly stated, is top priority. The list of fears by employees in Japan are plentiful. Are loved ones safe? Is my employment outlook intact ahead of a drop off in demand?

Can I gain access to consistent food and gasoline supplies? Obviously executives at the home bases in the United States want to soothe such frayed nerves, not only from a humanitarian standpoint but also because the workers are vital instruments to operating hard investments and facilitating the flow of information. From the contacts I have talked with, the loss of employee life has been nonexistent, but again there is unknown as phones are not working properly. It’s a fast evolving event, but the safety of workers is a positive amid the sea of worrying headlines. That said, accounts of select store closures is accurate. Retailers have been providing “assistance” to their employees in the form of (1) food; and (2) expense reimbursement for needed travel or lodging.